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Life insurance can be a lifesaver for those who want to provide money for their families after they’ve passed away. Although it’s an indisputably helpful tool, insurance policies aren’t always easy to comprehend. In fact, of the 60 percent of American adults who have life insurance, 35 percent of policyholders don’t fully grasp the benefits of their policy, and a quarter of survey respondents don’t know their policy options or how to purchase a plan.
Things get even more complicated when you consider the adjustments you can (and can’t) make to an existing policy. If you no longer require full coverage, for example, but need to fund other expenses, you may consider borrowing from your life insurance.
Here’s what you need to know about taking out a loan against your life insurance policy:
If you’ve got a term life insurance policy, stop right there—only whole or permanent policies qualify. That’s because term policies do not technically have cash value and expire at the end of your predetermined term. Whole life policies, on the other hand, typically have two values: the death benefit (the face value) and the cash value, which functions as a savings account. The loan, however, will not be taken from the death benefit, but borrowed against it, meaning that your insurance provider will treat your policy as collateral.
The Perks of Policy Loans
Taking out a policy loan is much simpler than applying for a bank loan or credit card. The timeline is short compared to other loan application processes, and because you’re basically borrowing money that you’ve already accrued, it doesn’t affect your credit.
- Come with lower interest rates, typically ranging from 5 to 8 percent
- Are not considered income and therefore remain tax-free
- Allow you to repay on your own schedule (goodbye, mandatory monthly payments!)
Drawbacks to Consider
Taking out a loan against your life insurance policy can give you access to money in a pinch, but there are a few pitfalls to keep in mind before you borrow. Most importantly, you run the risk of reducing the death benefit that will be paid out upon your passing. If your beneficiaries are on solid financial ground, this may not be an issue, but you should talk this over with your loved ones before you make any final decisions.
You’ll also need to keep a close eye on your loan balance—if it increases beyond the amount of the cash value, your policy may lapse or be surrendered. If a lapse occurs, the balance of your loan will be considered taxable income, and these taxes could wind up costing you a pretty penny depending on the initial loan amount.
Don’t forget about interest! Unless it’s paid out-of-pocket, interest will be added to the balance regardless of whether or not you pay in monthly installments. This could put your loan at risk of exceeding your policy’s cash value, causing the policy to lapse.
Whether you need the funds to pad out your retirement savings or to pay for an unexpected medical bill, borrowing against your life insurance policy can help you get out of a financial rut. Always consult a financial advisor before buying, selling, or borrowing to ensure you understand your options.